foxex: Backwardation Bounce

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Chart Advisor | Focus on the Price

By Gordon Scott, CMT

Tuesday, April 07, 2020

1. Oil markets close lower as stocks threaten to reverse

2. Oil and energy on the rebound?

3. Beware historically overpriced oil

Market Moves

Oil prices fell today even as energy sector stocks closed higher on average. State Street's Energy Sector index ETF (XLE) closed higher by two percent, a sharp contrast to the S&P 500 index (SPX) which closed one-half percent lower.

Today's price action created an interesting and rare two-day candle pattern referred to as a bearish "meeting lines" pattern (see chart below). The characteristics of this pattern are documented on websites from two candlestick experts: Tom Bulkowski and Steve Nison. Both agree the pattern is rare and not any better than random for the purposes of predicting the days that follow. However, Bulkowski makes an observation that has relevance after today's market action.

If the market is in the lower third of its price action for the year, then the direction the following day closes tends to touch off a significant swing move in that same direction for the days that follow. Considering that the CBOE Volatility index (VIX) inched higher today, it could be a tell. Nervous investors may indeed push prices lower during the remainder of the week if the market breaks lower at the open on Wednesday.

Meanwhile, oil prices have showed a distinct display of unusual backwardation lately. This is in contrast to the contango pattern that began in oil futures back in early February (see second chart below). These strange terms refer to whether the futures contracts with longer expiration dates have a different price than the contract that expires only one month away or less.

Contango is an unusual state for futures contract prices and it typically means futures traders expect prices to fall. Backwardation is the natural state of futures prices, however when the prices are unusually high for a later expiration, as they are now, it implies traders expect that commodity to rise in price. As discussed yesterday, a bullish move in oil prices likely forecasts an upward move in stock prices.

Oil and Energy on the Rebound?

Since the market hit bottom on March 23, it wasn't much of a surprise to see the technology sector lead that move. The chart below compares State Street's sector index ETFs for technology (XLK), energy (XLE), basic materials (XLB), industrial manufacturing (XLI), consumer staples (XLP), utilities (XLU), healthcare (XLV), and consumer discretionary (XLY) with its S&P 500 index ETF (SPY).

What may be a surprise to some chart watchers is that energy stocks have performed second best over that period (see chart below). This kind of pattern highlights the notion that investors are both interested in putting their money to work (technology) and taking risks for bigger returns (energy). That would normally be considered a very bullish posture, and for the short term, it may end up being that way.

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Beware Historically Overpriced Oil

Enthusiastic energy investors may want to consider the chart below (click for a larger sized graphic). This chart seems to show just why business professor Julian Simon would inevitably win his famous wager with biologist Paul Erlich over the notion of resource scarcity. In 2013 some analysts begin to question the wisdom behind that bet, however the recent collapse of oil prices may have less to do with COVID-19 and more to do with what Simon was betting on: that market forces, technology and human ingenuity would naturally weigh on commodity prices over time.

The geopolitical ramifications behind this chart are ponderously huge. It seems clear to any chart watcher that, in hindsight, OPEC's intervention in the oil markets all these years may have kept oil prices unnaturally high. Interventions such as this may prove, in the long run, unsustainable. Were such a trend to continue over the coming years, it could prove disastrous for states dependent on oil production. For example in Venezuela it seems the damage from this trend has already taken a terrible toll.

The Bottom Line

Yesterday's strong rally appeared ready to continue but investors sold stocks from the open all throughout the day, except in the energy sector where stocks managed to hold onto their gains. The dynamics of the oil market are important to watch right now. Short term they signal a potential rebound for stocks, but over a longer term, energy commodities may find pressure for lower prices.